3
06
Prociclicality of Systemic Credit Risk:
A Point-in-Time model for the Brazilian
Banking Systems Credit Portfolio Risk
Ana Paula Mussi Szabo Cherobim
Jorge Henrique de Frias Barbosa
Wesley Vieira da Silva
Determinants of the Demand for Overdraft
Limit Credit in the Brazilian Economy
Carlos Eduardo Balbi da Silveira
Directions for Risk Parameter Modeling
within a Basel II and III Context
Carlos Antonio Campos Nogueira
Ratings Migration Matrix for
Corporate-segment Companies - 2010/2011
Marcio Ferreira Torres
The monetary authorities of several countries pro-
pose a new prudential provision targeted at the sys-
temic credit risk. The provision would be created
during economic recovery and peak periods. The
study assumes the prociclicality of credit risk, that
is, the development of credit risk is directly associ-
ated with the macroeconomic environment.
30
The main purpose of the study was to identify the
factors that determine the demand for personal
credit. To this end, static and dynamic discrete re-
sponse regression models for panel data were used
to model the data of 56,898 overdraft customers of a
Brazilian bank, using balanced information.
54
The article covers the requirements with the great-
est impact on building testing and validating the in-
ference models used by Internal Risk Rating Sys-
tems IRRSs, with a focus on the retail and whole-
sale categories, the main targets of the modeling ef-
forts of Financial Institutions.
66
Classic migration matrices enable ascertaining
changes in the credit ratings of a group of compa-
nies over a certain period of time. This article shows
the rating migrations of almost 2,000 of the largest
Brazilian companies, with annual sales and/or total
assets in excess of R$ 200 million.
 54

Directions for
Risk Parameter
Modeling Within
a Basel II and III
Context

Carlos
Antonio
Campos
Nogueira
 55

Abstract
The Basel accord and its continuity documents
(Basel III) set many rules for the development, validation
and maintenance of Internal Credit Risk Rating Systems,
which are required for financial institutions to apply to IRB
(Internal Ratings Based) under either the basic (FIRB) or
advanced (AIRB) approaches. But the standards leave
gaps, in particular as regards the construction of internal
risk rating systems (IRRS) and the theoretical grounds of
these systems inference engines, which we call models.
The omission is purposeful and intended to give FIs lee-
way to build models and IRRS to best fit their characteris-
tics (customer base, local law, product types, etc.). Within
the range of these rules, FIs have been evolving along sev-
eral lines of operation that this paper will quickly address
within the context of credit risk.

Keywords: Internal Risk Rating Systems IRRS,

Loss Given Default- LGD, Exposure at Default EAD.

1. Concept cal criteria (e.g.: scorecard results) or

Although often used inter-
changeably, Internal Risk Rating
Systems and models are different,
though closely related, concepts. In-
ference models (whether statistical or
otherwise, such as neural networks)
are used to quantitatively predict the
risk parameters Probability of Default
(PD), Loss Given Default (LGD) and
Exposure at Default (EAD).
IRRS is a broader concept that
may or may not include an infer-
ence model at its heart. In essence,
an IRRS, as the name indicates, rates
obligors and/or exposures on a scale
of levels of credit risk, usually based
on the scores or ratings generated
by inference models, but also possi-
bly based on non-inference numeri-
even exclusively qualitative criteria of
a purely judgmental nature.
Generally speaking, IRRSs
use a mixture of numerical outcomes
(for risk parameters PD, LGD and
EAD) produced by inference mod-
els, to which qualitative criteria are
added, followed by the application
of a mapping rule for the results on
a rating scale with well defined lev-
els. Such levels may be identified by
letters (more commonly used for ob-
ligors in the wholesale segment) or
numbers that are usually designated
as scores, used most often to rate the
risk of consumers or SMEs.
The mapping method, when
based on the models predicted out-
comes for the risk parameters, im-
 56

plies the use of means (e.g.: the av-
erage value of the PDs of the various
obligors in a certain homogeneous
risk group, or pool). This method is an
integral part of the IRRS methodolo-
gy, as are the mathematical models
used in inference models.
The parameter-mapping rule
for pools involves subtleties even in the
segregation of the pools exposures,
which require a delicate compromise
between the stability of the ratings and
their granularity (number of pools). If
the granularity is too high (small range

Figure 1 Relationship between models and IRRSs

IRSS

Qualitative
criteria
Rating A

Rating B
Inference Model
models predictions

Rating H
Other quantitative
criteria
 57

Figure 2 Mapping risk parameters according to score/rating levels

Model output
Scores/ratings scale Average parameters parameters

Pool with A score/rating PDA LGDA EADA PD1

PD2
...
Pool with B score/rating PDB LGDB EADB LGD1
Averages
LGD2
calculation
...
EAD1
EAD2
Pool with H score/rating PDH LGDH EADH ...

of variation of the risk parameters asso- 2- On Models and the

ciated with each average), the IRRSs
discrimination capacity will increase,
but beyond a certain point stability is-
sues might arise, with many exposures
migrating from one pool to another and
eventually jeopardizing their meaning.
If, on the other hand, we chose a very
low granularity level, we might collect
together exposures with very different
risk profiles, and such poolings might
no longer be homogeneous from the
viewpoint of the exposures risk.
A comprehensive discussion
of IRRS, particularly as concerns
granularity, mapping rules and the
stability of rating scales lies beyond
the scope of this article, which will fo-
cus solely on the models involved, in
particular those for PD and LGD; we
will limit ourselves to the conceptu-
al issues relevant to Financial Institu-
tions that wish to migrate to IRB.
Basel II/III Rules
Basel II, as well as its Basel
III improvements and its local appli-
cation within the context of migration
to IRB (Central Bank of Brazil Circular
Letter No. 3.581, dated Mar/08/2012),
create requirements for internal risk
rating systems that go from exposures
segmentation to the risk parameters
(PD, LGD, EAD) generated as model
outputs, as well as the independent
variables used as model inputs.
This article addresses the re-
quirements with greatest impact on
the construction, testing and valida-
tion of the inference models used by
IRRS, focusing specuially on the retail
and wholesale categories, the main
targets of the modeling efforts of FIs.
1. Requirements for expo-
sure segmentation:

For the models to show good
predictive capacity, it is crucial to cat-
egorize the exposures whose data are
fed into the model, pooling them ac-
cording to similar risk profiles As a
consequence, information from the
credit contracts that make up the ex-
posures must be categorized as stip-
ulated by the Central Bank(Retail/
Wholesale).
The Retail category must be
divided into the sub-categories Home
equity/ Qualified retail revolving cred-
it/Other retail exposures.
Within each retail sub-catego-
ry, IFs may treat exposures according
to homogeneous risk groups (pools),
where ever exposure in a certain pool
must have the same values for the risk
parameters PD, LGD and EAD (the
average values associated with each
pool, according to the mapping pro-
cess seen in Fig. 2).
Different models exist for each
risk parameter, that is, there are spe-
cific models for PD, others for LGD
and a third type intended to predict
EAD. A single PD model may be used
for one or more pools. In addition, one
or more pools may show the same set
of risk parameters as predicted by the
respective models.
The Wholesale category must
be divided into the sub-categories Ex-
posures to individuals not covered by
the retail category and small and me-
dium enterprises (SMEs)/Specialized
Financings (Project Finance or Spe-
cific asset financing)/Other wholesale
exposures. The FI may, at its discre-
tion, create a sub-division of the SME
58
sub-category at the lower sales limit
(over 3.6M and under 48.6M annually)
for collective treatment according to
pools, as long as the same criterion is
used for the purposes of management
and pricing.
2. Quality of the data used
for model input variables:
The variables must be fed
with reliable data from within the
base for every obligor event in the rel-
evant pool. By reliable we mean, for
example, that static variable data on
the obligor and/or exposure must vary
little or according to trends, and that
both static and dynamic ones must
undergo semantic consistency tests
(e.g.: income does not fluctuate sig-
nificantly for civil servants). This reli-
ability must extend, within the base to
all obligor/exposure events addressed
by the models.
In addition, the domain varia-
tion of continuous and discrete vari-
ables must be small over time. The
absence of syntactic and semantic
variation within the domain must be
proven. To illustrate: a variable that
proposes to locate a retail obligor ac-
cording to annual income range may
do so on a discrete, 6-range domain
(0-5). That is, not only do the ranges
remain stable (they persist syntacti-
cally from 0 to 5) but they also retain
the same meaning(range 3, for exam-
ple, comprehends customers with in-
comes in the 30,001-50,000 range).
Finally, the independent vari-
ables (mode inputs) must prove their
explanatory capacity for the obligors
risk profile.

3. Criteria and Methodology:
The assumptions (definition of
default, definition of delinquency, loss,
etc.) and methodologies used (includ-
ing the statistical framework) must be
robust and widely tested by the market
as a whole.
4. Tests:
The models (and their respec-
tive IRRSs) require regular testing as to
their predictive capacity. This is done
by means of adherence testes, com-
paring the predicted results with ac-
tual observations, in what is known as
backtesting. For example, the probabil-
ities of default predicted by a PD model
must be tested against effective rates
of default for the pool(s) in question.
The gaps between the predicted and
observed rates may be analyzed graph-
ically via scatter charts or ROC curves,
or measured analytically by sensitivity
and specificity coefficients, or similar
metrics (Gini coefficients, etc.).
In addition to backtests, mod-
els must also undergo stress tests that
must consider, at least:
The occurrence of isolated
events or changes in economic or mar-
ket conditions affecting the institu-
tions ability to withstand the risks from
the exposures;
Specific scenario simulations
representing low- or medium-stress
situations affecting specific aspects
of the chosen IRB approach (FIRB or
AIRB);
To run stress tests, the data
must allow:
- Estimating the migration of
exposures across risk levels; and
59
- Quantifying the impact of
a relatively mild deterioration of the
credit market on the exposures risk
ratings.
3.Considerations
about PD Models:
3.1. At what Level of Detail
do PDs Have to be Determined?
One of the most controver-
sial aspects of the construction of PD
models concerns the decision to as-
sess the models output probabili-
ty of default at the obligor level (as
a whole, considering every exposure
on every product an obligor has with
the FI) or at the exposure level. And,
where a FI chooses to calculate both,
how to ensure the consistency of the
predictive capacity(e.g.: by prevent-
ing the obligors cross-product PD
from being lower than the PD on one
of the obligors specific exposures).
Determining PD at the obligor
level has the advantage of being more
consistent with the real nature of a de-
fault event, which is a result of the cu-
mulative and joint effect of several ob-
ligor commitments that exceed his or
her payment capacity (which may also
vary). As a guideline for Basel II com-
mitment, PD estimates must be at the
obligor or pool level (the latter being
accepted only for retail and SMEs),
as long as the definition of default is
also at the obligor level (for the pur-
poses of capital calculation and man-
agement)), to ensure backtesting con-
sistency. By definition, PD is the prob-
ability of an obligor defaulting within

a year, regardless of the facility/prod-
uct where the default will occur. This
is made very clear in BCBS Working
Paper 14 (see references at the end of
the article). At their most detailed lev-
el, PD are always obligor-specific.
PDS that determine PD at the
exposures pool level (obligor/prod-
uct) are accepted (for retail purposes
only) if the FI treats from the man-
agerial perspective default events
at the transaction level as well, that
is, an obligor in default only on con-
sumer credit would not be regard-
ed as an obligor in default (except for
the specific operation in default), and
would have retained his or her credit
card and overdraft limits an unusu-
al practice.
The credit for different prod-
ucts is priced differently for a single
obligor because LGD (the parameter
that reflects the transaction dimension
of risk) varies according to the prod-
uct (e.g.: whether collateral is involved,
maturity terms, the distribution of pay-
ments over time, etc.). Consequent-
ly, expected loss EL (PD times LGD)
also varies, affecting the share of the
spread associated with risk.
Obviously, PD models that as-
sess the parameter at the obligor level
may use as inputs (independent) var-
iables derived from information asso-
ciated with products/facilities (e.g.:
the total amount of the obligors on-
balance and exposures, average late
payment considering the various
products, etc.). Still, the model must
arrive at a single PD for the obligor,
regardless of the product.
60
3.2. On Low-default Portfolios
Another challenge and the
subject of lengthy debate is the con-
struction of PD models for portfo-
lios that, for various reasons, show
very low default rates, the so-called
Low Default Portfolios LDPs. Sta-
tistically, the scarcity of defaults may
hamper the performance of the more
commonplace modeling techniques,
reducing predictive capacity (large
backtest dispersion), compromising
the discrimination capacity and in-
creasing the volatility of PD.
The cause of the scarcity of
defaults varies from one portfolio to
another and across different FIs. The
most common causes include
The portfolio is relatively
new at the FI and therefore its internal
bases (which for some reason it can-
not or will not supplement externally)
lack a large number of historic cases
of default.
The portfolio is made up of
new entrants in the market, which oc-
curs when new social strata start to
get access to credit.
The portfolios composition
rules select obligors that, due to his-
toric financial robustness character-
istics, end up affecting the portfolio
(e.g.: top rating/score business firms
and individuals).
The last two types are called
systemic LDPs.
LDP modeling uses specific
techniques. The most frequently used
approaches include:
Bayesian based on expert
input (Dwyer);

Purely quantitative Bayesian
(Kiefer);
Pluto & Tasche;
Jafry & Shuermann (extend-
ed migration matrices dynamics);
Alan Forrest;
Wilde & Jackson (derived
from Pluto & Tasche, but using
CreditRisk+).
FIs use more than one of the
approaches above, depending on the
portfolio in question. E.g.: Pluto &
Tasche for old portfolios with large
numbers of clients with few (or none)
default events. And Jafry & Shuer-
mann for portfolios for less numerous
portfolios with some default events).
Before selecting an approach,
it is crucial to, in addition to consider-
ing the size of the portfolios population,
clearly determining whether the LDP is
systemic or not and which of the causes
listed above is relevant to explaining the
low number of default events.
A detailed discussion of the
methodologies used in each such ap-
proach lies beyond the scope of this
article, but can be easily found on the
Web. Here, we will simply present a
few characteristics and limitations of
each (wide error margins in parts of
the LDP spectrum), more specifically:
Annexation of neighbor or
similar portfolios not always availa-
ble within the FI itself, its subsidiaries
or external contributors.
Bayesian based on expert
input (Dwyer) expert input is usual-
ly difficult to obtain or the robustness
and stability of the input may be diffi-
cult to prove to the supervisor.
61
Purely quantitative Bayesi-
an (Kiefer) the subjective assump-
tions are difficult to prove to the su-
pervisor, unless they can be empiri-
cally demonstrated, which is difficult
by the very definition of an LDP.
Pluto & Tasche highly sen-
sitive and subjective confidence level.
In addition, the method vas very wide
margin errors when the number of cli-
ents of low-count portfolios varies.
Jafry & Shuermann (extend-
ed migration matrices dynamics) It
is difficult to prove sufficient robust-
ness to convince regulators for low-
count portfolios.
Alan Forrest Selection of
the cutoff levels is highly sensitive
and difficult to defend (before super-
visors).
Wilde & Jackson (de-
rived from Pluto & Tache, but using
CreditRisk+) the same as Pluto &
Tasche.
To offset these limitations, FIs
may (bur are not required to) bench-
mark (to select the best approach for
a certain portfolio), as covered in the
next topic.
3.3. Benchmarking
Both the Basel Accord and
Central Bank Circular Letter 3.581 ad-
vise the regular use of benchmarking
as an input for eventual model cali-
bration. Because it is a recommenda-
tion and not an obligation, there are
intense internal discussions at FIs on
the adoption of these periodic bench-
markings and, above all, on the sourc-
es used for comparison.

There are several reasons
to adopt benchmarking as a regular
practice. The main ones are:
The lack of widely accepted
tests requires supplementing back-
tests with one or more benchmarks.
Regulators often resort to
independent entities to provide them
with tools and PDs, scores or ratings
intended to run benchmarkings that
significantly simplify a formal over-
sight process.
The limitations inherent to
LDP modeling methods may be large-
ly mitigated by periodic calibration
based on benchmark results.
Two main kinds of benchmark-
ing are used to attain these objec-
tives:
One (which this article re-
fers to as Type 1), used to identify ex-
ogenous obligors (outliers), com-
pares PDs (or LGDs and EADs) from
similar pools obtained from several
FIs (this application is more appropri-
ate for Pool Data). In this case, there
is no intent to test the quality of the
IRRSs, but rather the possible inac-
curate categorization of specific obli-
gors (as input to the pool composition
adjustment process).
The other type (Type 2) uses
external ratings, scores or PDs (or
LGDs and EADs) for comparison with
the parameters calculated internally
by the relevant FIs IRRSs.
In type 1, the benchmarks are
made up of the aggregated data from
several FIs. This may be done by the
regulator/supervisor, by an independ-
ent public- or private-sector entity, or
62
both (the supervisor operating based
on data collected by an independent
entity).
In type 2, the ratings, scores,
or PDs are usually provided by third
parties, even where used by supervi-
sors. Some supervisors develop their
own with support from third parties
(with data collected by these third
parties or by the supervisors them-
selves).
Despite the obvious benefits,
adoption of the use of benchmarking
as a regular practice faces some ob-
stacles, including, in particular:
For type 1:
Obtaining samples (pools
or individuals) from various institu-
tions in order to create a homogene-
ous base (peer group) to serve as a
benchmark.
Converging on a consist-
ent rule for mapping the ratings on a
master scale.
Upon obtaining exogenous
occurrences, the analysis must be
supported by discrimination tech-
niques to separate the effects from
different methodologies from rating
deviations.
For type 2:
Selection of the source to be
used as a benchmark: Similarity ac-
rowss the assumptions used in var-
ious IRSSs is important, as are the
definitions of lateness, default and
loss. In the case of ratings scales,
also important is the underlying phi-
losophy (PIT or TTC). For PDs, wheth-
er they are dynamic or static. Note:
American and German banks tend to

use PIT ratings more often. English
and French ones, TTC ratings.
Definition of a correspond-
ence (mapping) rule for the internal
models estimations against the exter-
nal benchmarks (of particular impor-
tance in the case of pool PDs).
3.4. Other Topics
The scope of PD modeling in-
cludes many other topics that are the
subject of highly active discussion
and development. Some sources of
additional information can be found
at the end of this paper from the list
of bibliographic references
4. Considerations
about LGD Models
LGD modeling is far more chal-
lenging than PD modeling for several
reasons, chief among which:
The methodologies and the-
oretical bases are still developing and
are far less mature (tested by time and
the marketplace), than those for PD.
The great difficulty, for the
majority of FIs, forming a database
with sufficient information and data
history to ascertain LGD via the work-
out method, which is the intended ap-
proach for the medium and long run.
Many challenges are discussed
in a more comprehensive and deeper
manner in the article titled LGD Mode-
ling Challenges, which can be found in
issue #76 of this review.
Here, we address other sup-
plementary topics that are also the
subject of reflection for FIs modeling
teams.
63
4.1. On where to Interrupt
Workout Calculations
The Basel Accord recommends
- where the IF chooses to calculate LGD
via the workout method - taking every
recovery into account, but this is regard-
ed as a theoretical, long-term objective.
Meanwhile, both the Basel Committee
(BCBS) and the majority of regulators
acknowledge that, in practice, it is more
efficient and prudent for FIs to set limits
for the duration of the workout process,
for two main reasons:
Conservatism, as by ignoring re-
sidual receipts, LGD tends to be higher.
More quickly available mode-
ling data. One of the main difficulties for
FIs to adopt workout-based LGD models
lies in data availability (effective LGDs
with completed workouts) Extending
the calculation period to include post-
WO recoveries would only aggravate
the problem.
It is therefore acceptable for FIs to
set a limit for workout completion, which
may be based on percentage recovery
achieved (e.g.: 90%), term (e.g.: two years),
significant recovery event (e.g.: foreclo-
sure and sale of collateral), or a combina-
tion of the foregoing. In practice, this pre-
vents including post-WO recoveries, al-
though, in theory and motivated by per-
fectionism, calculation of an LGD might
be reopened after a post-WO receipt
and the models could be reprocessed ret-
roactively, but this would be impractical
and, given the frequency of such events,
its contribution to the models predictive
capacity would be irrelevant, bearing in
mind article 63, item II of Central Bank of
Brazil Circular Letter No. 3581:

Art. 63. Estimations of the PD,
LGD and EAD parameters must meet
the following requirements:
II - taking into consideration all
of the quantitative and qualitative infor-
mation available, according to the rele-
vance criterion;
4.2. On the Use of Binary
LGDs as Model Inputs
One way to address the chal-
lenge of accurately ascertaining ob-
served LGDs (the models dependent
input variable) is to use the so-called bi-
nary LGD.
The approach polarizes the val-
ues of input LGDs (for the dependent
variable) as either zero or 100%. The de-
cision to round LGD up or down to one
of the extremes is usually left to an au-
tomated routine (program) that uses a
random method or comparison with a
cutoff threshold.
It is a valid resource and with
clear benefits, specially:
It reduces the time and effort
involved in calculating workouts. To il-
lustrate: if a defaulting exposure un-
dergoing recovery has reached such
a point that LGD is already below the
threshold, it becomes available as a
modeling piece of data, as the polarized
value would already be zero, regardless
of any future recoveries.
It approximates the character-
istically bimodal distribution of LGD that
is frequent in some portfolios.
It enables using widespread
PD modeling tools such as Logit (log
regression), simpifying and expedit-
ing the formation of modeling teams
64
(which may derive from the teams that
model PD).
However, the decision to polar-
ize LGD may have disadvantages, in-
cluding:
Although admissible as an ap-
proach, depending on the manner and
scope of utilization by an FI, the su-
pervisor may interpret it as a conven-
ient simplification, a case of adapt-
ing the methodology to the availabili-
ty of (and preference for using) a (Log-
it) tool, rather than the outcome of the
search for a model with good predictive
powers. Logit works well for PD mod-
els because of the actual binary na-
ture of the observed variable (in default
or performing). For LGD, the actual ob-
served values lie on a continuum that is
not even limited to the [0,1] interval (al-
though negative LGDs end up being
compressed into LGD=0)
One must remember that the
argument that LGDs show bimodal dis-
tribution (the grounds for defending ap-
proximation via a binary model) is not
valid for every portfolio and may create
distortions (some portfolios are more
unimodally distributed and others show
a shallower U). Using a percentage
recovery threshold as a trigger to close
workout ascertainment may make the
distribution even more distant from bi-
modal/binary behavior.
The use of binary LGDs as an
input may create in wholesale portfoli-
os, as a result of leaps in the resulting
peak distribution (which, in turn, arises
from discrete changes due to the LGD
binarization method), large month-
to-month allocated capital variations,
 65

which may be difficult to explain to su-
pervisors. There is also the problem of
the compression of negative LGDs
into LGD=0 for some portfolios, such
as real-estate, for example, which tends
to create an LGD frequency distribution
that is closer to unimodal, but may con-
tain topical peaks.
For exposures treated as
pools, limiting only two LGD values as a
dependent variable may restrict diversi-
fication and cause concentrations (as a
result of the leaps described above for
wholesale) that are undesirable to both
the FI and the supervisor.
If this approach is selected, cau-
tion must be taken transforming work-
Author
out-based LGDs into binary values (to
create the dependent variable), using
thresholds that are consistent with the
respective portfolios/pools.
5. Conclusion
The diversity and dynamics of
topics relative to PD and LGD mode-
ling have been leading to countless
debates, most of which are still on-
going, in addition to abundant litera-
ture; this article may be just a teas-
er for those with an interest in the
subject and market practitioners,
who may do research and gain more
in-depth knowledge before making
their choices.

Carlos Antonio Campos Nogueira

A Physics graduate (PUC - RJ) and master of Astrophysics and Elementary Particles (Centro Brasileiro de Pesquisas
Fsicas - CBPF/CNPQ). A practice leader in the IT consulting area, with 27 years continuous experience, having provided
services to more than 40 companies in nearly 70 projects. Managing partner and founder of IntelliSearch.
E-mail can@intellisearch.com.br
References

Basel Accord International Convergence of Capital Measurement and Capital Standards: A Revised Framework -
Comprehensive Version (June 2006 version): http://www.bis.org/publ/bcbs128.pdf
Central Bank of Brazil Circular Letter No. 3.581, dated mar/08/2012, on the rules for implementing internal credit-risk
models (IRB).
Working Paper 14 Studies on the Validation of Internal Rating Systems: http://www.bis.org/publ/bcbs_wp14.
pdf?noframes=1
Basel II Implementation A guide to developing and validating a compliant, IRRS - Ozdemir, Miu (MC Graw Hill).
Credit Technology Review Serasa Experian No. #74, pp. 31 and 46.
Credit Technology Review Serasa Experian No. #76, p. 71.
Comparison of regression models for LGD estimation
Comparison of regression models for LGD estimation A. Arsova, M. Haralampieva, T. Tsvetanova Experian Decision
analytics 2011.